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Employee Equity as Compensation: Corporations are Better Than LLCs

In this article, we discuss another difference between corporations and limited liability companies (“LLCs”). Both are corporate entities and serve similar functions (such as providing a shield against personal liability for the owners). However, providing ownership equity as compensation is different for the two types of business entities. Caution is in order for LLCs. If your LLC is considering offering ownership unit options, it is important to consult both a good San Diego corporate attorney and a good tax accountant. As described below, the tax aspect is complicated.

Most people have heard about stock options as a form of compensation for employees of corporations. Stock options are pretty common. Offering stock — either at zero cost or for a set price — is a way of offering non-cash compensation to employees. Non-cash compensation is a valuable tool for startups, which might not have liquidity or might have cash flow issues. Stock, of course, is a form of ownership or equity in the corporation. Stock generally provides the owner of the stock the right to vote — usually one-share-one vote — for members of the board of directors. The board controls the corporation and makes all the major decisions.

Providing non-cash compensation in the same manner for limited liability companies (“LLCs”) can be done but is not as easy. A corporation has share of “stock,” whereas an LLC has “ownership units.” Those holding ownership units are generally entitled to vote for the managers who run the LLC. In theory, an LLC could offer non-cash compensation by offering — either at zero cost or for a set price — ownership units to employees.

However, caution should be taken before offering LLC ownership units to employee. In California, there are three types of LLCs that are allowed – single-member LLCs, member-managed LLCs, and manager-managed LLCs. As the name would imply, the first is an LLC with only one owner member. It is self-evident, but still must be stated, that offering ownership units in a single-member LLC will change the character of the LLC — it will no longer be single-member. That has ramifications for both corporate and tax issues.

Aside from single-member LLCs becoming multiple-member LLCs, offering LLC ownership units causes potential tax-related complications for the employee of an LLC. For taxation purposes, multi-member LLCs are treated in the same manner as partnerships by default. There is a long-standing Internal Revenue Service rule that states that partners are not “employees” and cannot be treated as “employees.” This is important for who pays the employment taxes (the LLC or the employee) and which employment taxes are paid (FICA vs SECA).

Once ownership units in the LLC are given to an LLC employee, the employee becomes an “owner” — becomes a partner — under IRS income tax rules. Thereafter, under the rules, the former-employee stops receiving a W-2 form, begins receiving a K-1 form, must begin making quarterly estimated tax deposits and must pay self-employment taxes. This is often confusing for the employee and a hassle. Plus, if the self-reported estimated payments are insufficient, then a large tax bill is due in mid-April. Note that same result occurs for an “employee” who becomes a “member” if the LLC has elected to be treated as an S-corporation for tax purposes. An S-corporation also provides the K-1 form to its owners.

Interestingly enough, a single-member LLC is treated by the IRS as a “disregarded entity” and is allowed to treat its single member as an “employee.” Offering ownership units to other employees of a single-member LLC will destroy the ability of the LLC to be treated as a “disregarded entity.”

As can be seen, the tax aspect of offering LLC ownership units to employee is complicated. As noted above, caution is in order.

Contact San Diego Corporate Law Today

For more information, contact attorney Michael Leonard, Esq., of San Diego Corporate Law. Mr. Leonard can be reached at (858) 483-9200 or via email. Mr. Leonard can assist with the formation of your business entity — corporations, LLCs, and others — can help with business mergers and acquisitions, can draft and review all your business contracts including commercial leases, and can assist with intellectual property matters such as establishing and licensing trademarks, copyrights, and trade secrets.

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Michael J. Leonard, Esq., is an award winning attorney whose practice focuses on corporate, securities, contract, and intellectual property law for small and medium businesses. In his practice, Mr. Leonard routinely assists his clients with the formation of business entities, financing through the sale of debt and equity securities, mergers and acquisitions, contract drafting and review including commercial leases, and establishment and licensing of trademarks, copyrights, and trade secrets.